Working capital represents the operational liquidity and is the cash you use as a business to run the day to day operations. These operations include paying short-term debts, paying suppliers as well as your employees. Working capital is considered part of operating capital and is also directly proportional to current assets. Current assets include debtors that will pay their debts in less than 12 months, stock and cash in the bank and in liquidity.
How to calculate working capital
Working capital is calculated by subtracting current liabilities from current assets. If current assets are not more than current liabilities then the business is said to be operating under working capital deficiency. This is also referred to as a working capital deficit.
The disadvantage of a working capital deficit
Having a working capital deficit is a disadvantage to your business as it may lead to facing difficulty in paying off current liabilities, running the day to day operations or running bankrupt as a business. A positive working capital is required for any business and a working capital loan ensures that your business does not face a deficit. This is ideal for most small and medium-sized business SMEs as they often require working capital boosts. To find out more about working capital solutions click here.
The working capital ratio
The working capital ratio is the measure of the health of your business. The ratio is calculated by dividing your current liabilities by your current assets. This is used to determine whether your business has enough operating capital over your short-term debt. If the ratio is anywhere below 1 indicates a negative working capital, not a good idea for your business. If the working capital ratio is above 2 is also not good for your business as it indicates that the company does not invest excess working assets.
A good working capital ratio is between 1.2 and 2. A declining ratio is alarming as it indicates that the business collection process is slow. Fastening them, however, can boost the ratio of your working capital.
Working capital solutions may include speeding up the payment process, thus reducing the working capital cycle (WCC) or getting working capital loans. These loans include; short-term loans and invoice finance.
1. Speed up the collection processes
This reduces the working capital cycle thus increasing the working capital ratio. By speeding up the payment or the collection process you are assured of having a positive working capital ratio as your business do not wait for payments for long periods of time.
A good example is when you pay your suppliers within a period of 30 days yet your customers wait for up to 90 days before paying you. This is quite strenuous for your business as you have to keep up with delays. Reducing the payment procedure can be done by accepting instant payment for example with card readers, specifying payment dates on invoices to avoid confusion accepting credit cards and rewarding and penalizing clients for payments with policies.
2. Short term loans
Loans from banks and other financial institutions may also offer short-term solutions to a working capital deficit. Although loans are relatively more costly they can offer liquidity of physical assets that are used as collateral in case not paid and offer cash. Bank loans are, however, time-consuming require a lot of paperwork and might not be a viable option for small and medium-sized businesses SMEs. Bank loans also require physical assets to be used as collateral for the loans and many small businesses do not have the requirement. SACCOs and other micro-finance institutions may also offer solutions to working capital in form of loans.
3. Invoice finance
Invoice finance uses the customer unpaid invoices to give cash to the business. This may be either using invoice factoring or invoice discounting. The two are relatively different although at the end of the day they use invoices issued by the customers and due to be paid to get access to quick cash.
When using invoice factoring the business agrees to a financier to offer the unpaid invoices to them in return receive a certain percentage of the invoice in cash. This might be up to 95%. The financier then goes ahead to pick the payments once the customers make them. Click to find out more about invoice factoring.
Invoice discounting, on the other hand, does not hand over the responsibility of the buyer’s payment to a third party but leaves it with the business in question. The business the makes monthly payments to the financier upon the invoices accepted.
These two methods have their unique advantages and disadvantages. Invoice factoring is more secure as the liability goes out of the business in question. It is, however, more expensive as it requires the financier to cover the ledger expenses.
Invoice discounting is more confidential as customers are not necessarily notified of it but maybe insecure in case customers take time to honor their invoices as the business will have monthly dues to take care of.
At Momentum Credit we offer working capital solutions. To find out more about invoice factoring and invoice discounting as methods of invoice finance, check out the complete guide here.